Davidson on Temin and Vines

Paul Davidson debates Peter Temin and David Vines in this INET working paper. I had criticized Temin and Vines before here and here. Although in general I agree with Paul, in my view, there is a problem with Keynes’ Bancor Plan kind of solution, that is the one that puts an emphasis on the need for surplus countries to carry the burden of external adjustment. It is really, in the world we live with a hegemonic currency, the role of the issuer of the international reserve currency to carry the burden. In other words, pace Mr. Trump, it is the US that needs to provide global demand, not China.

PS: China is losing reserves, faster than any one expected. But it’s worth remembering that they do still have significant current account surpluses, and that China faces no external constraint.

Peter Temin explains the Great Recession and the slow recovery

A bit more on Peter Temin and David Vines book on Keynes. The explanation of the Great Recession is based on a traditional negative shock to the IS curve. Temin famously wrote the response Friedman and Schwartz Monetarist view of the Great Depression, his Did Monetary Forces Cause the Great Depression?, in which a contraction of consumption, and the IS, rather than the contraction of money supply and the LM was seen as the central story.*

 So the same is essentially at work now. They say:

“the IS curve in the US moved left a great distance after the Global Financial Crisis and the adjustments that followed. It moved so far that the new IS curve no longer crossed the LM curve at a positive interest rate.”

As can be seen below.

I can live with the representation of the Great Recession as a collapse of the IS (and yes the negative slope might be explained by other elements of demand, not investment, being inverse related to the rate of interest, like consumption or housing investment). I'm more troubled by the notion that the slow recovery is caused by the negative rate of interest, which in this case precludes the intersection of the IS and LM (note that, contrary to Krugman's negative rate, the equilibrium would not be the full employment one). But I do agree with the implied solution, not defended very forcefully, to my surprise, in the book, i.e. expansionary fiscal policy to bring the economy back to full employment.

In part, Temin and Vines do not defend fiscal policy strongly, because they bring the issues of an open economy to the forefront of the discussion, using James Meade's notion of internal and external balances. It's far from clear that they think this applies to the US, but in general their solution for a country with an external problem and unemployment, would be depreciation and austerity. In their words:

“The indebted country requires a combination of the two policies. Devaluation will increase exports and reduce imports. Austerity—just the right amount—will reduce home demand for goods and leave room for the production of extra exports and the home-produced goods that replace imports. The right combination of policies will move the economy to the intersection of the external balance line and the internal balance line, or even further down the internal balance line into the region of external surplus if the country is to begin repaying its debt.”

Note that without austerity the economy would overheat. That's a lot of confidence in the expansionary power of devaluation. As noted here several times, a devaluation can be contractionary, and it often 'solves' the balance of payments problem for that reason. Devaluation and austerity, by the way, were, and still are, the traditional policy measures imposed by the IMF on indebted countries. The implication seems to be that a combination of devaluation with austerity would produce, in the US too, a healthier recovery. The book is strangely positive on austerity, because of the external balance requirements, a position that, at least in this recession, other New Keynesians like Krugman and DeLong have temporarily abandoned.

And their analysis in the book about the post-war boom, the so-called Golden Age, is also not very good. Temin and Vines, even though they recognize the role of the Marshall Plan, emphasize the positive role of the IMF in promoting growth, and suggest that the IMF is an improved version of Keynes' proposal at Bretton Woods. In their words:

“The cooperation stimulated by American generosity in the Marshall Plan was a hallmark of postwar European progress... The IMF—an improved version of Keynes’ Clearing Union—eventually became a crucial policy-making institution... The IMF, which Keynes helped to design, was central to the restoration of growth.”

The Marshall Plan, which depended not just on generosity, but on fear of the Soviets, was clearly central. The role of the IMF in a global recovery of the 50s and 60s is hard to defend though. And Keynes Plan did not involve punishing indebted countries, which is what depreciation and austerity do, quite the opposite. In fact, Keynes was relegated to the debates on what became the World Bank at Bretton Woods, while Harry Dexter White was the central figure in the creation of the IMF. And the World Bank was, until the 1980s, a more benign instrument of US external economic policy, one might add.

But Temin and Vines also botch that one, and say:

“The World Bank, which was less central than the IMF, facilitated long-run growth. The World Bank was designed to help re-create the international pattern of productive trade that Keynes had described in The Economic Consequences of the Peace.”

Yes, the World Bank was created to recreate the pre-war pattern of trade, with the periphery selling commodities, and the center manufactures, and the British as the hegemonic... Oh wait. Yeah that makes no sense either.

* In later research Temin came closer to Eichengreen in putting the Gold Standard at the center of the Great Depression. For example, in his Lessons from the Great Depression. The seeds of his positive view on the role of depreciation are associated to his view that the abandonment of the Gold Standard was at the heart of the recovery. For a critique of that go here.

The Economist on the end of economic history

The Economist has noticed Peter Temin's paper on the death of economic history (on which I had posted before) and suggests that "since the financial crisis there has been something of a minor revival." There isn't much of an explanation of why there is a revival, or much evidence for the revival, I might add. The reason alluded for the supposed revival is that "three big questions in economics over the past few years have become battles over economic history, rather than theory in its own right." These three questions would be the effect of public debt on growth, the causes of inequality, and the effects of inflation and deflation.

The economic history content in the debates related to the three questions, in all fairness, is thin at best. And the problems with the debates actually do arise from a common acceptance of neoclassical economics, and are, thus, rooted in theory. Reinhart and Rogoff are not economic historians, and their discussion of debt, for example when compared to John Brewer's discussion of the role of debt in the rise of the British Military-Fiscal State, is poor at best. There is some discussion of the correlation with growth, inflation and currency movements, with limited understanding of causality. Which, as it turns, was botched by the misuse of data. The same can be said about Piketty (and now this Rognlie twist; he had vanished; my previous issue with him here), that uses mainstream theory that does not fit his data (which is better and shows the rise of inequality in the last three decades), but lacks any sense of history. There is no understanding of the social forces behind the rise of inequality in Piketty's work. And the idea that those that are afraid of inflation now have some basis on the history of "the risk hyperinflation has posed to democracy" is beyond preposterous. Not just because there is no risk of hyperinflation in any advanced economy at the moment (and that shows lack of theoretical understanding of what causes this phenomenon), but worse, it tends to obscure that the Great Depression, not the 1923 hyperinflation, brought down the Weimar Republic. Seriously, unemployment, the collapse of the economy creates the conditions for the rise of fascists (go check Greece now)

Note that marginalism always had a complicated relation with economic history. The German Historical School can be seen, or at least some authors within the school like Roscher and Schmoller, as noted by Bill McColloch (see second essay here), as part of the marginalist school. And Max Weber's views, which put Marx's relation between the economic base and the superstructure upside down, might be seen as the basis for a neoclassical theory of history. But the fact is that Weberian analysis was never embraced or even well understood in mainstream circles, even if it would be the kind of theory of history that would fit their analysis. The same applies to Douglas North's New Institutionalism.

My impression is that the decline of economic history, and history of economics I would add, within the mainstream of the profession, a subject that as noted by Temin had peaked in the 1970s, is essentially tied to the result of the capital debates, the rise of what I referred to as the return of vulgar economics, and the segregation of heterodox economists. It's a particular problem of the broader crisis of economics. And the revival is overstated. As much as the mainstream did not, and will not be abandoned in spite of its evident failures during the last (current) crisis, do not expect economic history courses (or history of thought ones) to be reinstated or created in the departments at the 'top' universities. The average mainstream economist will remain ignorant of history and the history of its own field. The Economist writers are a good example of the consequences of that.

Keynes and the abandonment of the Quantity Theory of Money

I've been reading Peter Temin and David Vines new book Keynes: Useful Economics for the World Economy (see also this). It is a very introductory and conventional reading of Keynes, with the distinctive characteristic that describes the development of Keynes' ideas in the proper historical context. This is good, since Temin is an illustrious economic historian. But he is not a history of economic thought scholar, and that has important implications in this case.

If there is any doubt about the conventional reading of Keynes, one is reminded by them that Keynes theoretical innovation is that: "he abandoned the assumption that prices are flexible which had been made by almost all previous economists—including by him in his Treatise on Money—for the more appropriate assumption for the 1930s: sticky prices.” No notice that the whole chapter 19 of the General Theory (GT) is about wage and price flexibility to show that it does not solve the unemployment problem, and it actually makes it worse.

But that is not the the main problem with the book. That is, in fact, the common reading among both Old and New Keynesians, with the latter providing microfoundations for rigidities. The authors claim that: “in order to free the analysis from the assumption of full employment, Keynes had to free himself from the Quantity Theory too.” Actually that is incorrect, since one can have endogenous money, and abandon the Quantity Theory of Money (QTM), without getting rid of Say's Law, or the neoclassical version of it which implies full employment, as indeed Keynes had done in the Treatise on Money (TM), his Wicksellian book.

The view of the Keynesian Revolution as a movement from price flexibility to price rigidity is well documented, and even if it has no basis in Keynes, it might acceptable to some authors. Krugman, who is not a historian of thought, explicitly says he does not care what Keynes actually said, for example. Note that saying that Keynesian policies are necessary as a result of price rigidities is not the same that saying that Keynes actually said that. And for historians of economic thought the difference is important.

More problematic is the idea of the Keynesian Revolution as a movement away from the QTM. There is a lot of scholarship in this direction, including some from Keynes' own disciples, like Richard Kahn in his The Making of the Keynesian Revolution. Actually in the GT Keynes goes back to an exogenous money approach, and in that sense is closer to the QTM than in the TM, which had endogenous money. The important thing in the GT is that Keynes noted that the natural rate of interest in his TM should be abandoned. That is, the idea that the interest rate brings investment into equilibrium with full employment savings had to be substituted by the notion of changes in income bringing savings into equilibrium with autonomous investment. The theory of interest or monetary theory comes later as a result of the abandonment of the Loanable Funds Theory. This is not to say that the abandonment of the Quantity Theory of Money is not important, but clearly it is not sufficient to lead to a theory of effective demand. 

The book also tries to show that there is a continuity in thinking between The Economic Consequences of the Peace and the discussions about the reorganization of the world economy at Bretton Woods. This is hard to defend, in particular since the book itself shows that Keynes' theoretical views changed as a result of the economic policy events, like the return to the Gold Standard at the pre-war parity, and the Great Depression. One of the important things about Keynes is exactly that, as stated in the phrase often attributed to him, when he was proven wrong, he changed his mind.

Keynes on the causes of the Great Depression

By 1932 a draft of the General Theory (GT) was basically finished, including the central concept of effective demand, and Keynes have moved away from the Wicksellian framework of the Treatise on Money (TM). From a policy point of view the new view implied that the cause of the Great Depression was less the high rates of interest (above the natural rate), and the emphasis on the Gold Standard, that had dominated his views in the TM, to a more straightforward blame on reduced spending in the US.

In The Means to Prosperity from 1933, in which most of his policy views were expounded (and published before the GT) Keynes argues that:

Note that he clearly suggests that the global crisis had its epicenter in the US. Also, even though he is concerned with the role of expenditure in the level of activity, he still refers to the recovery as having price effects ('raising world prices').

PS: Arguably those authors like Eichengreen and Temin that emphasize the role of the Gold Standard remain closer to the TM and its Wicksellian framework (which would make sense for New Keynesian authors), while Romer, even though she remains firmly wedded to the idea of a natural rate, would be closer to the Keynes of The Means to Prosperity and the GT. See older post here.

What can we learn from the Depression?

Free Exchange has discussed in a recent post the academic views on the Great Depression. They suggest that recent research (say the last 20 years or so) has produced a different view, and "that many traditional views about the causes of the Depression have been overturned by academics in recent decades." In particular, they suggest that neither protectionism nor the financial crash are seen as central anymore. They correctly note that the dominant view, associated to Barry Eichengreen and Peter Temin,* now puts an emphasis on the effects of the Gold Standard (note that Keynes also emphasized the role of the Gold Standard, to which he referred to as a 'barbarous relic'). 

And by the way that means that the consensus is that a demand shock caused the Depression. Note that a few authors have pushed the Real Business Cycle (RBC) story in recent times. For example, Prescott argues that:

“In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment.”

In other words, the changes in incentives led to less supply of labor and less demand for investment goods by firms. Same ideas have been put forward by Cole and Ohanian, and by popularizers like Amity Shlaes in her The Forgotten Man. However, most of the New Deal regulations that the revisionists abhor, actually came to late to have caused the Depression. They generally try to explain the 'slow' recovery (growth averaged 8% in the first FDR term) as a result of the New Deal, and leave the question of what was the supply side shock that caused the Depression.

Lucas, who converted to RBC at some point in the 1980s, asked (cited here) poignantly: "Where is the productivity shock that cuts output in half in that period? Is it a flood or a hurricane? If it really happened, shouldn't we be able to see it in the data?" For that reason Lucas still believes, like Friedman, that the Fed did it. And if one is going to blame regulation for the duration of the Depression, one must deal with the fact that in the 1950s, if anything, labor and financial regulations were as stringent, if not more, than in the 1930s and unemployment was fairly low.

A more subtle critique of the conventional view, and its emphasis on the Gold Standard comes from Christina Romer. She suggests that the path of American output and unemployment before 1931 can be explained quite well with only domestic factors, and that even after 1931, international factors affected American economic conditions mainly through their impact on American policy decisions. Note that that this is not incompatible with Kindleberger's view that the US, in the process of becoming the hegemon, was central for the global economic collapse.

This should cast some doubts on FE's conclusion that:

"putting all the blame on Wall Street for the Great Depression -- or on bankers in the current crisis -- does not stand up to historical scrutiny. The responsibility may more properly lie in a complex combination of factors, like how global financial systems are structured."

Romer notes that in the US the collapse in consumption was more important than in other economies (harking back to Peter Temin's reply to Friedman that it was the collapse in consumption, not monetary policy, that caused the Depression). And the collapse in the demand for consumer durables, which depended on credit for their purchase, was affected by financial conditions. Romer argues:

“Both the initial recession in the United States in the summer of 1929 and the acceleration of the decline in late 1929 and 1930 are ultimately attributable to the stock market boom and bust of the late 1920s. The stock market boom is the prime explanation for why the Federal Reserve was pursuing tight monetary policy starting in 1928. The stock market crash is the prime source for the collapse in durable goods purchases starting in November 1929.”

So the financial bubble and the crash did matter, and John Kenneth Galbraith (among others) was correct about it. I would add that income distribution, which we know from Piketty and Saez, was as bad in the 1920s as now, did also play a role in the bubble and the expansion of private indebtedness. So Wall Street was to blame indeed, as much as it should be too in the recent Great Recession.

* Kindleberger, in his classic The World in Depression, goes further and suggests that it was the absence of an hegemon that acted as a source of demand in situations of crises (distressed markets), as a stabilizer of exchange rates, and as a source of international finance (an international lender of last resort) that caused  the Depression, since the UK was incapable and the US unwilling to assume that position. The Depression was essentially an hegemonic crisis.

PS: For further reading my forthcoming paper in the Cambridge Journal of Economics here.

Peter Temin on the strange death of economic history

Peter Temin recounts in this paper the vanishing (apparently complete by 2010) of economic history from the MIT curriculum. History of thought has probably vanished even before, if it was taught at all. He says that:

"Economic history at MIT reached its peak in the 1970s with three teachers* of the subject to graduates and undergraduates alike. It declined until economic history vanished both from the faculty and the graduate program around 2010."

He notes that the most famous economic historian graduated from MIT was Christina Romer, which, it must be emphasized, in her famous paper on the Great Depression claims that fiscal policy (and to a great extent the New Deal) was not responsible for the recovery. For her it was the non-sterilized inflows of gold that increased the money supply [yep, the most important historian graduated at MIT is more of a Monetarist than a Keynesian; New Keynesians are peculiar that way; for more go here].

Ideologically this is the result of the same forces that led to Fukuyama's hubristic announcement of the death of history after the fall of real communism in Eastern Europe. And the New Economic History, that received two of the Sveriges Riksbank Prize in Economics (aka the Nobel, but not really) given to North and Fogel, is part of the problem, as Temin notes. He says:

"In terms of the class struggle ... the coalition of theory and econometrics left economic history out of power in the counsels of economics. Proponents of the New Economic History were using more and more econometrics in their work, but they were no match for theorists."

That is why Temin does not consider the work of Acemoglu, including his recent Why Nations Fail to be good economic history. In his words the book:

"is an example of Whig history in which good policies make for progress and bad policies preclude it. Only transitions from bad to good are considered in this colorful but still monotonic story. The clear implication is that if countries can copy the policies of English-speaking countries, they will prosper."

For my critique of the book go here. At any rate, economic history, as well as history of economic thought, should be at the center of the teaching of economics.

* Temin who was hired to replace W.W. Rostow, Evsey Domar and C. P. Kindleberger.

A Shackled Revolution? The Bubble Act and Financial Regulation in 18th Century England

New Working Paper by Bill McColloch, which refutes anti-Keynesian (crowding out) views on the Industrial Revolution (IR). From the abstract:

"Revisionist estimates of growth rates during the British industrial revolution, though largely successful in presenting a more modest picture of Britain’s ‘take-off’ prior to the 1830s, have also posed fresh analytical difficulties for champions of the new economic history. If 18th-century Britain was witness to a diffuse explosion of ‘useful knowledge,’ why did aggregate growth rates or industrial output growth rates not more closely shadow the pace of technological change? In effort to explain this paradox, Peter Temin and Hans-Joachim Voth have claimed that a few key institutional restrictions on financial markets – namely the Bubble Act, and tightening of usury laws in 1714 – served to amplify the "crowding out" impact of government borrowing. Against this vision, the present paper contends that the adverse impact of financial regulation and state borrowing in 18th century Britain has been greatly overstated. To this end, the paper first briefly outlines the historical context in which the Bubble Act emerged, before turning to survey the existing diversity of perspectives on the Act’s lasting impact. It is then argued that there is little evidence to support the view that the Bubble Act significantly restricted firms’ access to capital. Following this, it is suggested that the “crowding out” model, theoretical shortcomings aside, is largely inapplicable to 18th century Britain. The savings-constrained vision of British capital markets significantly downplays the extent to which the Bank of England, though founded as an institution to manage the public debt, provided the entire financial system with liquidity in the 18th century."

The paper by Temin and Voth is here. Their recently published book is here.

Crafts and Harley's re-interpretation of the IR in Britain, alluded to in the text, is available here (subscription required). The classic book on the British IR that Crafts and Harley try to supersede is by Deane and Cole (here). A discussion of the two views by Temin is available here.

On whether the British government had a role in financing the IR, it is worth remembering Pressnell's (subscription required) words, for whom:

"Amongst the half-truths of economic history is the generalization that British Governments did not finance the Industrial Revolution. That public financial aid was not a regular and conscious process cannot be doubted; equally, it is indisputable that Government was not distinguished during the eighteenth and early nineteenth centuries by the provision of financial facilities commensurate with a period of economic expansion. In practice, however, a considerable volume of public money swelled the funds of private bankers, and in this indirect fashion helped to fructify private enterprise."

Pressnell suggests that country bankers were often tax collectors, and closely related to industrial activities. The incredible growth of public debt, to 260% of GDP by the end of the Napoleonic Wars, and the increase in government revenue to pay for debt service, implied a signiifcant increase in liquidity which is associated to the financing of the IR.

PS: Newton (pictured above) lost his pants in the South Sea Bubble, and also was famous for getting the exchange rate between gold and silver wrong (he was the Master of the Mint), leading to hoarding of silver, and the beggining of an effective Gold Standard in Britain.